Opinion: Get away from utility stocks before they topple

TimMullaney

A previous version of this article incorrectly identified Eric Ervin as Ethan Ervin. It has now been corrected.

STR/AFP/Getty Images

As stock prices move to all-time highs, it’s to be expected that some people are going to complain about bubbles.

Here’s what’s not expected: The biggest bubble may be in utility stocks.

Consider it a side effect of the long, increasingly frantic hunt for yield in a post-financial crisis world: Utilities
XLU, +0.44%
are the hottest sector in the market, rising 17% this year and hitting price-to-earnings multiples 26% higher than their long-term norm, according to S&P Capital IQ chief strategist Sam Stovall.

All for a business where demand for the product is actually shrinking slightly, threatened by emerging technology. That means the dividends that are attracting people are in long-term danger.

“They’re like an ice cube melting,” said Eric Ervin, CEO of San Diego-based Reality Shares, which runs an exchange-traded fund that looks for companies likely to raise or cut their dividends.

This year, the two sectors with the market’s biggest gains lack, well, all of these.

The two hot sectors are utilities and energy
OSX, +0.42%
led by the high-yielding master limited partnerships whose ability to sustain dividends at anything like the 7.1% average of the Alerian MLP IndexAMZ, -0.09%
depends crucially on the price of oil
US:CLU6
now about $45. Neither is a classic investment case. In another oddity, Morgan Stanley says biotech stocks
IBB, +0.52%
are now cheaper than slow-growth, yield-paying pharma companies — a notable reversal from 2014, when Federal Reserve Chairwoman Janet Yellen warned of biotech froth.

If you want growth and income, invest in growth and income. Technology stocks are historically cheap even as more of them pay dividends.

A 3.4% yield isn’t nearly enough to compensate for this kind of risk. It’s also not nearly enough to offset the history of utilities tanking after periods where they lead the market.

Take 2000-2002. As the dot-com bubble popped, it was a good time to hold utilities, which rose 57% that year, according to S&P Capital IQ. But the next two year, the piper got paid, to the tune of a 30% drop each year. A 20% gain in 2011 preceded two bad years where utilities lost 16% as the market rose by half. And, again, in 2015: They were down 11%, after a 29% gain in 2014. As interest rates rise and a 3.4% yield gets less exotic, it’s likely to happen again.

Energy is a more complicated case. Profits are expected to have their first positive year-over-year expansion in the fourth quarter of this year, and nearly quadruple next year, according to Capital IQ. Energy stocks in the S&P 500 yield a weighted average of 2.7%.

On the plus side, predictions that the cost of producing U.S. shale oil would plummet are proving true. The average cost has fallen 22% a year since 2013, and is now down to between $25 and $30 a barrel, Rystad Energy says. That makes the case for an earnings rebound plausible — as long as those lower costs don’t drive up output, adding to the current supply glut, and make prices fall again.

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But the market is valuing energy companies collectively at 29 times 2017 estimates, Capital IQ says. If you’re expecting a capital gain on today’s prices, as multiples revert to historical means less than half that, you’d need a bigger earnings rebound than you’re getting.

After taxes, you’d get nearly as much income from long-term municipal bonds, and with a lot less principal risk.

If you want growth and income, invest in growth and income. Capital IQ’s data show technology stocks are historically cheap even as more of them pay dividends: They’re up only half as much as utilities this year, trade at 16 times 2017 earnings, and are 15% cheaper than their historical average, Stovall says. Their average yield is 1.6%, but it’s easy to find healthy tech companies that pay 3% or more.

And the companies underlying them grow faster than the economy, which utilities haven’t done in years and will probably never do again.

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